A new set of rules for social games

The tractors, fuzzy pets, and mobster ambushes might be virtual, but the past few weeks have shown that the battle for social-gaming market share is very, very real.

Monday saw the long-rumored announcement of gamemaker Playfish's big-ticket sale to Electronic Arts, a big win for a product niche some had dismissed early on as faddish and silly. But it comes at a time when there's ongoing press blitz over how much social-gaming companies rely on lucrative but potentially misleading means of advertising in the form of lead-generating offers.

Both of these developments have changed the course of an industry moving at hyperspeed--but was anybody really sure where it was going in the first place? Playfish, arguably, was the safest buy in the space. Headquartered in the U.K., its revenues were solid--one analyst estimates it'll pull in $100 million this year--and it was less reliant on controversial third-party offer companies than many of its competitors.

"I'd say hats off to EA," said Jeremy Liew of Lightspeed Venture Partners, which has invested in social-gaming firms like Serious Business and RockYou. "It's a much lower-fidelity product (meaning cheaper to produce) that appeals to a much simpler consumer (than the traditional gamer), but they recognized the risk that it poses to their business and they were willing to take a decisive action."

Playfish had a great exit, as they say in the venture capital world. Things might not go quite as smoothly for other social-gaming companies.

Here's some background. The social gaming craze grew out of an array of new time-wasters that involved neither a significant commitment nor a complicated set of rules. Companies like Zynga, Playdom, and SGN attracted millions of investor dollars, and word has it that former MySpace CEO Chris DeWolfe wants to roll up a bunch of smaller companies into another powerhouse. And now that EA has a big social-gaming company in its arsenal, other older video game manufacturers might push fast-forward on investments or acquisitions in the space.

Playfish, manufacturer of games like Pet Society and Restaurant City, was at the time of its buy either the second or third biggest company in the space--behind Zynga, but neck-and-neck with Playdom. Like most of its competitors, it makes money through a combination of advertising and the sale of virtual goods, which players can either purchase with real-world cash or can earn by completing offers and surveys from third-party companies like Offerpal Media or Super Rewards.

The industry common wisdom is that Playfish's revenue is less reliant on those offer companies than some other social-network gamemakers. That's a good thing, considering the bad press the likes of Offerpal have been pulling in recently. In a highly-publicized confrontation with Offerpal CEO Anu Shukla (who resigned from her post in a matter of days), TechCrunch blogger Michael Arrington launched a full-on assault against the business of social-game offers. They're no more than scams, he alleged, since many offers actually have hidden costs attached for consumers: entering your cell phone number to receive the results of a quiz you took, for example, may actually tack a charge onto your phone bill.

"The industry hasn't done, in general, as good a job as it could have of maintaining the offers' integrity to users," Jason Oberfest, a former MySpace executive who recently joined the executive team of iPhone and social-network gaming company Ngmoco. "(Playfish was) way more conservative in how they've used offers, and I'm sure, frankly, that their revenue per user has probably suffered a little as a result, but it's clearly played out well for them."

Even without the offers controversy, social gaming is a volatile industry: few if any of the companies in the space are older than five years. It's a hit-driven business, with companies needing to work around the clock to keep audiences playing and push out new games lest the current sensations grow stale. There's already a history of lawsuits and legal threats, often over rival gamemakers' extremely similar products. When bloggers started their keyboard assault on the likes of Offerpal, it was only adding to the sector's reputation for fast money, cutthroat competition, and occasionally shady business practices.

Playfish may have exited just in time. Some of the small to medium-size social-gaming companies are undoubtedly hunting for buyers, and Zynga has gotten so big that rumors suggest it may be looking to file for an IPO. With all the controversy over offers and whether social-gaming companies' revenues were inflated by misleading ads, there's a chance that their profits--and hence, their valuations to prospective investors or buyers--may take a significant hit.

Still, venture capitalist Liew doesn't think that will make a huge difference. "Zynga said 30 percent of their revenue comes from offers, and I think that's pretty representative of the industry," he estimated. "Let's say 20 percent of the offers are scammy, so that's 6 percent of the revenue of these companies that's at risk. It doesn't change the answer as to whether this is a valuable company."

Maybe so, but there are other complications. Facebook, the biggest destination for social games, continues to make alterations to its developer platform. Most recently, the massive social network announced some changes that limit games' and other applications' appearance in members' news feeds, a move that may make it more difficult for start-ups to enter the space as well as drive already-big companies to purchase more advertising space in order to get the word out about their latest games and keep acquiring new customers.

Social-gaming companies are already some of the biggest advertisers on Facebook, with the biggest one, Zynga, spending as much as $50 million this year on Facebook ads alone, according to estimates from industry insiders. If revenues are potentially going to decline (and no one can quite agree on how much) as a result of a crackdown on offers, but advertising costs may go up as companies attempt to increase their reach on Facebook, that makes their balance sheets look less sunny.

For all the ugliness of the Offerpal mess, it could have been much less pleasant if the scrutiny was coming from lawmakers rather than industry bloggers--like the several state attorneys general who were particularly vocal about stamping out misleading offers in display ads, but haven't yet targeted social networks. And changes appear to be imminent. Zynga CEO Mark Pincus announced Sunday that the company has blocked all cost-per-action offers until the situation calms down and it's easier to weed out scams. Playdom, too, says it is continuing to make its business less reliant on offers.

"Offers are an important industry issue, and particularly important for our players," CEO John Pleasants, a former high-ranking EA exec who left for the fast-growing company this summer, said of Playdom in an e-mail to CNET News. "When I joined as CEO, Playdom began a company-wide effort to deliver a quality user experience on our offer walls...We've dropped more than 1,500 offers that don't meet our standards. In tandem with these efforts, we have actively grown the direct payment portion of our business; offers, otherwise known as CPA advertising, currently account for less than 20 percent of our revenue and continue to shrink."

Social-gaming companies don't want to look like criminal operations, nor do they want to look like they're turning a blind eye to questionable third-party activity. While Zynga and Playdom are big enough to sacrifice that revenue, some other companies that are likely hunting for buyers might not fare so well. As a result, future acquisitions in the space could easily be much smaller. Price tags could be lower if revenues deflate, and now that EA's made its buy, the list of potential buyers who could actually pay $300 million is now one company shorter. There's a legitimate question as to who would actually be buying; even optimistic insiders say that this could get in the way of another Playfish-like exit.

"I think the more important question is who can pay. Because if you want to buy Zynga, it's way more than Playfish. If you want to buy Playdom, I think it's going to be equivalent, if not a little bit more than Playfish," Liew said. "There are a lot of people who want to get into social gaming that don't have the ability to write a check of that size, and so they are going to be looking at the next tier of companies. That's where I think we're going to see some action."

In other words, we still don't know who the next real winner will be.